Pick up a newspaper and there is sure to be news or talk about inflation and it’s one of the key figures that central banks and policy makers use in determining economic settings, so, lets take a closer look at this variable….

What is inflation?
People can view inflation in one of two ways, the prices of goods are going up or another way is that the value of a dollar is going down. The first view would more than likely be your thoughts after purchasing goods for $15 that you bought yesterday for $14. Or you might think ‘did that guy just rip me?’!

For a real world example lets look at the cost of a litre of milk which in 1980 cost around $0.50, in 2008 it’s around the region of $1.90. That’s around 280% increase over 28 years. Therefore, based on those prices, the price of milk rose by 4.88% per year.

How is Inflation Measured?
Every quarter the ABS (Australian Bureau of Statistics) calculate what’s called the Consumer Price Index (CPI). The CPI is a measure of the overall cost of goods and services purchased by a typical consumer. You can find a complete description of how the CPI is calculated at the ABS - Australian Consumer price Index: Concepts, Sources and Methods [PDF].

This CPI figure provides an insight to the cost of living over time, and when the CPI rises it basically means that the typical consumer has to spend more to maintain the same standard of living. The term ‘inflation’ is used to describe this rising cost of living and the term ‘inflation rate‘ describes the percentage change in this level to the previous period.

You may also hear of these two different figures -

Headline Inflation: Includes all items, or all 11 groups of items, measured in the CPI.

Underlying Inflation: also known as ‘core’ inflation, it is a record of the inflation rate excluding sharp or quickly reversed movements in prices or one-off shocks that create short-term volatility in measured inflation. Various methods can/are used to obtain a measure of underlying inflation.

There are also various other inflation statistics calculated and published including exclusion-based measures - such as the CPI excluding volatile items, and statistical measures - such as the trimmed mean and weighted median.

Other Measures of Inflation
The GDP Deflator: The implicit GDP (Gross Domestic Product) deflator is the economy’s aggregate price index, movements in the implicit GDP deflator reflect changes not only in consumer goods and services but also in capital goods, exports, and government services which are produced in Australia. Because it isn’t based on a fixed basket of goods and services like the CPI, the GDP deflator has an advantage in that consumption patterns or the introduction of new goods and services are automatically reflected in the figure.

TD Securities/Melbourne Institute Inflation Gauge: In 2002 TD Securities in partnership with the Melbourne Institute started the monthly Inflation Gauge project which provides estimates of month to month price movements. Each month, the Inflation Gauge collects prices for around 1000 goods and services, effectively, a scaled down version of the ABS CPI which collects prices on over 100,000 goods.

With all these inflation figures it’s important to remember to compare apples against apples! And who’s using which figures to calculate what!

Graph: Year Ended Headline Inflation in Australia - 1970-2007. Source: ABS

How does Inflation effect the Consumer?
In simple terms, inflation reduces your purchasing power. If inflation is 10% what costs a $10,000 today will cost $11,000 next year and $12,100 the year after. So, if you were on a fixed income, that means your standard of living, over time, would be reducing as you struggle to purchase the same goods and services you purchased earlier.

Thus the reasons as to why you’ll hear unions and consumer groups asking for wages and payments to be ‘indexed’ to inflation, although, that does become complicated as wage increases may be swapped for tax relief by government policy makers therefore after tax income may well keep up with inflation.

Inflation also affects the person saving money, for example: Jenny deposits $10,000 at 10% for one year, inflation is at 10%. At the end of the year Jenny will have $11,000 and is $1,000 better off, or is she? Remember, in our equation inflation is running at 10%, so, something that cost $10,000 when Jenny deposited her money now costs $11,000. Jenny’s purchasing power is exactly the same.

And this is where we are introduced to what is called the ‘Real Interest Rate’ which is simply the ‘Nominal Interest Rate’ (the rate you are being offered or given) minus Inflation Rate. While the Nominal Interest Rate provides you with the growth in dollar terms, the Real Interest Rate provides you with the growth in terms of purchasing power. For example if the interest rate offered for a deposit is 6% and inflation is at 3% the Real Interest Rate would be 3%.

We also need to remember that if purchasing power is going down due to inflation that also means that asset prices are going up. Inflation has many effects and can create winners and losers. A person borrowing money can be benefited by unexpected high inflation which causes an increase in wages and asset prices and in effect reducing the ‘value’ of the amount of money borrowed, and of course the lender suffers by receiving repayments in dollars with less purchasing power.

Unpredictable or high rates of inflation can also have many unseen costs including that of the shop keeper or merchant continually reprinting price lists, price distortions between those adjusting for inflation and those not, confusion for investors leading to mis-allocating funds and for governments constant adjustment of policy due to ‘bracket creep’ (e.g if inflation was fueling wages and tax brackets remained unadjusted everyone would end up in high tax brackets!).

How Much Inflation is Bad?
There is, and probably always will be, much debate over the many facets of inflation by economic theorists as has been since the 18th century! Generally, moderate and stable inflation is viewed as beneficial to the economy whereas unpredictable or high rates of inflation are viewed as bad.

Many economic theorists also draw relationships between the inflation rate and money supply- the quantity theory of money and money neutrality, inflation rate and employment - NAIRU (non-accelerating inflation rate of unemployment) and Natural Rate Hypothesis all of which reminds us that it’s a figure which can’t be looked at in isolation.

We also need to remember inflations opposites and offsiders - Deflation (typified by falling prices, unemployment and economic depression), HyperInflation (inflation rate exceeding 50%) and Stagflation (when the economy isn’t growing but prices are).

You can find the quarterly updates on Consumer Price Index at the ABS and Consumer Price Inflation reports and forecasts at the RBA

This post is continues at What Causes Inflation?

Macroeconomics
cpi, inflation